Current issues in economics

Why have New Zealand’s interest rates been higher than other OECD countries?

The April Economic Overview publication from Westpac Bank published a feature article focusing on why New Zealand has relatively high interest rates. A paper written by Treasury came up with two views:

1. The Risk Premium View
2. The Excess Demand View
The Risk Premium View
Interest rates in different countries can diverge with different perceptions of risk or inflation. Although New Zealand’s inflation or exchange rate are not volatile in relation to other countries, there is unusually high levels of nationla debt. While our government debt is relatively low in comparison to other countries it is our overall debt which is running at 80% of GDP which is causing concern. This would tend to push up interest rates higher than other countries with lower debt levels, while also pushing the exchange rate lower than it would otherwise be. The graph below plots the average inflation-adjusted interest rates against net foreign debt for a range of countries, suggests that this is broadly true.

The Excess Demand View.
The exchange rate can increase especially as investors look for higher yields as a country might have higher intesest rates – known as the ‘carry trade’. Investors will pile into higher-yielding currencies only up to the point where the exchange rate has become sufficiently ‘overvalued’ for its expected depreciation to offset the prospective interest rate gains. Elaborating on the carry trade idea the significant amount of aggregate demand in the NZ economy has kept the NZ$ high. This strong level of domestic demand has been to the detriment of savings and has also meant that the Reserve Bank has had to keep interest rates above those countries that have higher savings rates. Furthermore increases in domestic demand have meant:– a higher trade deficit
– significant foreign debt
– an overvalued exchange rate

Is saving the answer?
Saving is not by itself the panacea however there is a high liklihood that there could be lower interest rates and a lower exchange rate. Higher savings would also be rewarded with lower borrowing costs but contrary to the first point, lower foreign debt servicing costs and a more positive report from the credit rating agencies the NZ$ would be inclined to appreciate.